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Friday, May 23, 2008

The Conventinonal Wisdom on Deflation

The Conventional wisdom on deflation is that it is economically harmful and should be avoided at all costs. Consequently, no central bank explicitly targets deflation and few observers would dare say anything nice about deflation. The origins of this deflation orthodoxy can be traced to the painful deflation experience during the Great Depression of the 1930s. Japan's experience with deflation and its weak economy in the 1990s only reinforced this view. The modern economic psyche, therefore, has been programmed to go into fits at the first sign of any deflationary pressures.

This aversion to deflation can seen in the figure below that shows the number of articles on U.S. deflation in major world newspapers and the U.S. inflation rate for the years 1992-2004. During this time there were two deflation scares--one 1998 and the other in 2003--when the inflation rate dropped below 2%. As you can see the number of deflation articles spiked around these deflation scares, with most of the articles expressing anxiety over deflation. [Click on graph to enlarge.]

[The number of deflation articles comes from Lexus-Nexus search with the keywords “deflation” and "United States" or "U.S." Included in the search was a string of words and word roots associated with deflation’s potentially harmful and adverse consequences (e.g. zero nominal interest rate bound, debt burden, liquidity trap, economic weakness). I assume that any article having these key words is expressing at some level anxiety or concern over deflation.]

As some of you know, I have a problem with this deflation orthodoxy because it fails to distinguish between deflationary pressures arising from a negative aggregate demand shock versus that arising from a positive aggregate supply shock. As the above figure indicates, almost everyone assumed the deflationary pressures in 1998 and 2003 were harmful when in fact the data suggests that much of it was the result of the rapid productivity growth in those two years. This deflation orthodoxy explains why the Fed lowered its policy rate to historic lows: it, like most everyone else, thought the deflation of 2003 was of the harmful form. Because of the deflation orthodoxy, then, the Fed pushed the real federal funds rate to historic lows at the very time the rapid productivity growth was suggesting a higher natural interest rate. As I have argued elsewhere, this set off a credit and housing boom-bust cycle that we are now trying to sort out.

I hope going forward that conventional wisdom of deflation will emerge to a more nuanced view that distinguishes between the harmful aggregated demand-induced deflation and the more benign aggregate supply-induced deflation.